Stock market averages have been sliding steadily
since May 15th. The Dow is only 600 points, the Nasdaq less than a 100
points from the lows set April 4th of this year. Although the US economy
is not officially in a recession (defined as 2 quarters of negative growth,) US
corporations are definitely feeling a "profits recession" with earnings falling
17.3% in the quarter ending June 30th, currently forecast to fall 14.2% in
the quarter ending September 30th and falling 2.1% in the quarter ending
December 31st.
Our January forecast for 2001 was for the S&P 500 to gain 10-12% by
year-end, but this was based on our expectation that earnings would grow
10-15%. At this point, it is highly unlikely that the S&P 500,
currently down 14.7% on the year, will even manage to break even.
In March we discussed these parameters which, with
the exception of earnings, were generally bullish for stocks
1. Falling interest rates
2. Rising dollar
3. Tame inflation
4. Falling commodity prices
5. Low unemployment
6. Reasonable company valuations
7. Stable political situation
8. Absence of war
9. Growing corporate earnings
As we see now, the earnings situation was deteriorating much further than
we imagined. This time a year ago, corporate earnings were rising at
double digit rates and Gross Domestic Product was expanding at a 7% annual
rate. 1 year later, GDP is growing at just a 0.2% rate - this is the
equivalent of going from 80 MPH to 5MPH in 100 yards (and the passengers whack
their faces into the dashboard.) We had thought that GDP growth would slow
in 2001 to 3-3.5% and that earnings growth, while moderate, would still be
positive.
This chart shows the YTD performance of different sectors in the stock
market:
Even in a bear market, some sectors (for example, Consumer Services which
includes healthcare) are up on the year. However, technology, which still
remains the largest component of the major averages, accounts for most of this
year's decline. Many "blue chip" techs are at multi-year lows. Declines of 30% were expected
by us given how well these stocks performed in 1999, but 70-80%? That was
a surprise to us. Among the top 50 stocks by market cap, only Microsoft,
IBM, Dell and BankAmerica are up on the year.
Many of these companies are oversold on investors'
disappointment that technology is, in fact, not immune to the business
cycle. Two years ago investors
thought that these companies were interest rate insensitive (which to a
degree was true because their customers were paying with venture capital cash or
stocks) and that customers would buy technology no matter what to remain
competitive.
In fact, borrowing costs have increased for all
companies despite the Fed cuts (spreads that banks or investors charge on loans
or high yield debt have been widening for 18 months and VC cash is
history.) Furthermore, companies gorged on technology in the run-up to Y2K
and in response to the Internet. All this technology will be upgraded over
next three years (think personal computer business cycles) but not necessarily
in the next year (especially as new routers etc. can be bought over E-Bay at a
fraction of their usual pricing.)
Consumer spending has held together despite an uptick in the unemployment
rate. Lower mortgage rates, which drove a wave of mortgage refinancing
this spring, put more money in the pockets of the average consumer on an ongoing
basis than the much ballyhooed tax cut. Corporate spending, however, is on
hold until current capacity excesses are addressed. The area of greatest
excess capacity is in broadband transmission (about 90%). The cost of
transmitting a unit of data has fallen 40%/year for three years which no one
predicted (thus the bankruptcies of quite a few telecom companies over the last
year.) But the history of technology is the tale of demand rising to meet
supply. For example, the first personal computer with a hard-drive held
10MB which at the time seemed excessive. Twenty years later, 1 gig (1,000
MB) barely seems enough given the operating system, MPG files, digital photos
etc.
What is the worst case scenario? The last time the S&P 500
declined 2 years in a row was in 1973-4 (peak to trough down 55%) and, as we've
pointed out repeatedly, the US economy and political situation are not remotely
as bad now as then. The S&P 500 is down 26.6% from the March 2000
high, and even if it declines a little further, we believe that the worst is
past. A truly horrible scenario, where the averages decline 75% over 12
years (which describes the performance of the Japanese Nikkei since 1989) is
just not plausible to us (the popping of our tech bubble, while painful, does
not match the bursting of the Japanese real estate boom which destroyed the
capital of banks and corporation alike and will not be resolved without the
restructuring of the entire Japanese society.)
Bottom line: we're looking for a catalyst to drive
stock prices higher.
We know that earnings comparisons will get easier
later this year (companies results will be compared against the crummy results
from late 2000 as opposed to the stellar results of 1999.) We know that
the technology excesses are working their way out. We know that, while the
first wave of the Internet economy is past, the second wave is just
starting. We know that the positive effects of the interest rate cuts are
just now reaching the economy. We know that the risk of investing in
stocks is lowest when the economy is doing poorly. We know that investor's
psychology, bearish to the point that rise in prices is met with more selling,
will eventually turn bullish again. So over the last 9 months we've
increased our equity exposure from 75% to 90%. Our clients haven't seen
the benefit yet; it looks like we'll deliver negative returns this
year. But a year from now, and three years from now, and five years from
now, we expect stocks to be higher and we will not sell stocks at these
levels.
As always, we are available to discuss clients'
individual situations.
Best regards,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com